What’s Ahead for 2004

After a slow and confusing economic recovery, 2004 will be a year of solid improvement building on positive news, including the capture of Saddam Hussein, at the close of 2003.

New technology and changing public policy, as theUnited Statesfaces another presidential election, will also shape the business world in the coming year, predict Wharton faculty, who were interviewed by Knowledge@Wharton on five key sectors: the economy, the banking industry, airlines, telecommunications and health care.

Wharton finance professor Jeremy Siegel suggests that GDP will rise 3-4% after adjusting for inflation, and unemployment will decline as new job growth begins to take off. “I’m optimistic,” he says. “I think it’s going to be a good year.” Stocks will continue to do well, particularly in the first half of the year, before rising interest rates could put a damper on share prices. Rates on 10-year treasuries could rise to 5% by the end of 2004, up from the current 4.25%, he notes.

The Dow Jones Industrial Average will trade in a range of 9,000 to 12,000 during the year and is likely to close between 10,500 and 11,000, Siegel predicts. The NASDAQ will not rise as much because it has already appreciated substantially in 2003. “Saddam’s capture is a clear positive for the equity market. But the Bush administration must capitalize on this event by pressing a more ambitious roadmap to peace in theMiddle East, one that will involve more sacrifices by both Israelis and Palestinians. Unless some settlement can be made, terrorism will continue as a threat, although the capture of Saddam probably reduces the threat somewhat near-term.”

In addition to the threat of terror, Siegel says, another possible shock to the system could come with sharply rising interest rates as a result of a rapid decline in the dollar. Rising import or oil prices – which might be driven by instability in theMiddle East– could also set the economy back.

Siegel, who has researched the long-term performance of stocks, suggests that the current market is unusual because it appears to have no grossly undervalued sectors. One exception might be pharmaceuticals where selected stocks could hold more long-term potential than their current valuations indicate, he says.

Looking back at historic trends, Siegel notes that the third year in a presidential term is usually the best for the economy, and the fourth year is typically second best. “I think we’ve proved that again in this cycle.”

Looking to Merge

Richard Herring, co-director of Wharton’sFinancialInstitutionsCenter, says that while the Federal Reserve has indicated the economy faces an equal risk of deflation and inflation, he finds inflation the more likely scenario. The global economy may be about to head into an expansionary period, which would drive up prices for commodities and other goods.

The current term of long-time inflation-fighter Alan Greenspan, chairman of the U.S. Federal Reserve, ends in June when Greenspan will be 78. “We have been lucky that Alan Greenspan seems to be in wonderful health and loves his job, but he isn’t a spring chicken anymore,” says Herring. “There are a lot of talented people out there who could do the job, but we need to rely on the President to choose one who will be sensitive to inflation. That hasn’t always been true.”

According toHerring,U.S.interest rates may rise if investors grow concerned about large government deficits, or if a declining dollar leads to massive repatriation of foreign investment. However, he says, that does not seem to be an immediate threat. “It is not inconceivable that we’ll look upon this as a time of remarkably low interest rates.”

Internationally,Europestill has not fully responded to the creation of a single market or its currency, the euro, says Herring. “There have been remarkably few cross-border mergers inEuropeand, in a sense, they have an unfinished agenda.”Japanalso remains a concern, because the country has dealt with its long-term economic problems by consolidating banks into larger and larger institutions. The Japanese, Herring adds, have not had great success in managing bank mergers. “One hopes they are going to be building better banks when they make them bigger, but it’s a challenge.”

Knowledge@Wharton High School

Meanwhile, the U.S. banking and finance industries are likely to restart a consolidation that was interrupted by the bear market, predicts Herring, who points to the proposed mergers of the St. Paul Companies, and Travelers Property Casualty and Bank of America and FleetBoston Financial. “If in fact markets have returned to a more euphoric phase, then this is the vanguard of a new wave.”

Banks will be looking for merger partners to expand their businesses geographically, he adds, but also across financial sectors in hopes of emulating Citigroup’s successful model. “The troubling thing as you look back at these mergers is that very few have actually built value for shareholders. It does look like the market is going to be tougher at evaluating them.”

Can Airlines Reinvent Themselves?

An improved economy will boost the fortunes of the airline industry, which has been in a slump driven by the economic slowdown and the terror attacks ofSept. 11, 2001, according to W. Bruce Allen, professor of business and public policy at Wharton.

Consumers with increasing discretionary income typically choose to travel farther, and faster, leading them to book airline seats rather than plan a driving vacation, he notes. “I’m optimistic that in terms of traffic the market will come back. We have become a footloose kind of economy that is more leisure-based; one of the things consumers like to do with their leisure is go to Disney World andNew Orleans.”

The business traveler will also return to the skies, predicts Allen. “Some of these guys may have been lost because they discovered teleconferences, but I still think people want to see the whites of the eyes of the people they’re dealing with.”

The key question facing the industry is whether big carriers such as United, Delta and American, will be nimble enough to benefit from the up-tick. During the recent downturn smaller regional airlines, including Jet Blue, Southwest, Air Tran and Frontier, have been picking up market share in cities where they operate. “Now that people are comfortable with the new carriers, will they go back to the old carriers?” asks Allen.

At the same time, he adds, the big airlines are operating under much higher cost structures than their new competitors. Some have tried to reinvent themselves by forming smaller, low-cost airlines within their own companies such as United’s Ted and Delta’s Song, which replaced Delta Express. Allen says that strategy has failed in the past, pointing to US Airways’ MetroJet. “The real question is can you get labor to buy in and work like they’re working at Southwest and not at United or Delta.”

Passenger concern over security diminishes with each day that goes by without another incident like the attacks on Sept. 11, 2001, Allen points out, adding that airlines and the government have improved security systems that left travelers lined up outside airports for hours in the weeks after those attacks. Airlines for their part are concerned the government will require additional screening of cargo traveling in the belly of passenger planes. Passenger baggage is screened, but not the mail and other bulk packages that generate lucrative business for airlines in their excess capacity.

VoIP and Voice over WiFi

In telecommunications, Voice over Internet Protocol (VoIP), which allows consumers to make telephone calls over the Internet, will grow in importance early in the new year, predicts Gerald Faulhaber, Wharton professor of business and public policy.

AT&T, the nation’s largestU.S.long-distance provider, recently announced it will begin selling telephone service using VoIP and expects to be operating in 100 markets by the end of the first quarter of 2004. Time Warner Cable, the second-largest cable company in America, has been testing VoIP technology in Portland, Maine, since last May and now intends to roll out service to its customers across the country. Comcast, Cablevision Systems and Cox Communications also are offering VoIP service on a limited basis.

The industry is gearing up for a debate on how the technology will be regulated, say Faulhaber. The FCC has formed a working group on VoIP and has held hearings on whether VoIP should be subject to the same kinds of regulations that apply to telephone service now.“It’s going to be an interesting battle,” he notes.

In October, the U.S. District Court inMinnesotaruled that the Minnesota Public Utilities Commission can not apply state telecommunication regulations to Vonage, a VoIP provider. The Court wrote: “State regulation would effectively decimate Congress’s mandate that the Internet remain unfettered by regulation.”

Faulhaber says that despite a pro-business administration in the White House, the FCC has had a difficult time selling deregulation politically. “Anything that is painted as deregulation runs into a political firestorm. It gets painted in the media as pandering to business interests.”

By the end of the year, Faulhaber predicts, attention will turn to Voice over WiFi, technology that allows telephone communications over wireless networks, primarily through laptops. Verizon is experimenting with a system and QUALCOMM has tests running inWashington,D.C.andSan Diego, says Faulhaber. Data speed transmission is competitive with DSL, he adds, and VoWiFi “could become a killer.”

Wall Street continues to punish telecommunications firms that are investing, according to Faulhaber, who says businesses do not appear to be rushing into buying new telecommunications equipment although they are buying essential items. “Business will have to spend on telecom. It’s essential. But I don’t see a big splurge yet.”

The High Costs of Health Care

Healthcare has been dominated in the past year by the debate over legislation that extends drug coverage to Medicare recipients for the first time since the government-funded health system for the elderly and disabled was created 40 years ago.

After all the discussion, there will be very little effect of the legislation in 2004, suggests Mark Pauly, Wharton professor of healthcare systems. The only impact of the bill in 2004 may be enhanced payments to Medicare managed care providers and a discount card that will give recipients reduced prices on out-of-pocket drug costs.

The drug benefit will not kick in until 2006 and provisions aimed at making Medicare more competitive will not go into effect until 2010, Pauly notes. The new Medicare drug benefit will not have much impact on drug company sales, profits or share prices, he says, adding that drug firms may lose business if enough employer-financed plans reduce or eliminate drug benefits now that Medicare has stepped in. “I don’t see this as a give-away to the pharmaceutical firms and if enough employers drop coverage, it can be a take-back.”

Overall health spending, which topped $1.4 trillion in 2001, the last year for which official figures are available, will continue to outpace inflation at a real rate of 5-7%, Pauly forecasts. Drug spending, which had been driving the rise in health care costs in recent years, may drop off in 2004 as the industry loses patent protection on some key blockbuster therapies.

The rate of increase in health care premiums is also likely to slow. “I would be surprised if health premiums in 2004 grow more rapidly than 2003,” says Pauly. “We’ve gone through heavy gains and the market is competitive. The fundamental trends in spending seem to be slowing rather than rising.”

The upcoming presidential campaign is likely to focus on coverage of the nation’s 44 million uninsured, but after the Medicare legislation there is little left in the federal budget for more than modest proposals, according to Pauly. “There will be a lot of discussion, but I’m not sure I’d predict action. State and federal budgets will be a constraint, and the uninsured are not as politically influential as the elderly – and the elderly got to the trough first.”

Technology

Increasingly, technology is making it possible for children to educate each other -- from anywhere in the world -- in a more personal way that can sometimes promote deeper learning than traditional methods offer.